Summary of Proposals

Summary of Proposals (February 2, 1999)

Taxable REIT Subsidiaries Endorsed

Background

A REIT must receive at least 75% of its gross income from rents and mortgage income, and at least 95% of its gross income from those items plus all types of dividends and interest. A REIT cannot own more than 10% of the voting securities of a non-REIT corporation, and the stock of any non-REIT corporation cannot be worth more than 5% of the REIT's assets. Since 1988, the IRS has allowed REITs to invest in taxable corporations (called "third party service subsidiaries") to provide services (e.g., property management services to a partner) so long as the investment meets the 5 and 10% asset tests.

If a REIT provides non-customary services (e.g., cleaning interior offices) to a tenant beyond a de minimus amount, all payments from that tenant do not qualify under the relevant REIT tax tests. This "tainting" effect also applies if the services are rendered by a REIT's third party service subsidiary.

In its proposed budget for Fiscal Year 1999, the Administration a year ago proposed changing the 10% asset test described above to prohibit a REIT from owning more than 10% of the vote or value of a non-REIT corporation. In deference to all the IRS rulings issued since 1988 concerning third party service subsidiaries, the Treasury Department proposed to apply this repeal of the subsidiary structure only to new subsidiaries created after the "date of first committee action" and to any expansion (after such date) of business activities of existing third party service subsidiaries.

In 1999, the Treasury Department stated that its proposed "freeze" of third party service subsidiaries was based on two factors. First, Treasury said that there was the potential for the third party service subsidiary to reduce its corporate income tax obligations by deducting interest payments to the REIT owning most of its economic interest. Second, Treasury voiced concern about the propriety of a REIT substantially profiting from businesses conduct by the third party service subsidiary that it viewed as non-real estate related.

In the past year, NAREIT has conducted a dialogue with the Treasury Department and the Congress on ways in which the Administration's concerns could be addressed while allowing the REIT industry to meet competitive demands from the marketplace.

New Proposal

10% Vote or Value Asset Test. In the proposed Fiscal Year 2000 Budget released yesterday, the Administration again recommended changing the 10% asset test to prohibit a REIT from owning more than 10% of the vote or value of a non-REIT C corporation.

Significant Exception. However, in a significant departure, the Administration recognized the need for the REIT industry to evolve to remain competitive:

"Many of the businesses performed by the REIT subsidiaries are natural outgrowths of a REIT's traditional operations, such as third-party management and development businesses. While it is inappropriate for the earnings from these non-REIT businesses to be sheltered through a REIT, it is also counter-intuitive to prevent these entities from taking advantage of their evolving experiences and expanding into areas where their expertise may be of significant value."

The Budget proposal calls for an exception to the new 10% asset test for a new category of companies: taxable REIT subsidiaries ("TRSs"). There would be two types of TRSs under the proposal.

A qualified business subsidiary ("QBS") would be the successor to third party service subsidiaries. A QBS would be able to provide management and other services to non-tenants of the REIT. Presumably, as under current law, a QBS could render services to a REIT's tenants that a REIT could perform directly without "tainting" the underlying rents.

An qualified independent contractor subsidiary ("QIKS") would be allowed to perform non-customary and other currently prohibited services to REIT tenants as well as activities that could be performed by a QBS.

Size Limits. The Administration proposed two size limitations for TRSs. First, all TRSs owned by a REIT could not represent more than 15% of the value of the REIT's total assets. Second, the value of all QIKSs could not represent more than 5% of the value of the REIT's assets. Presumably, the asset valuations would be based on methods similar to those used for the current 25% asset test.

Anti-earnings Stripping. The Administration proposed the total disallowance of a TRS's interest payments on debt to, or guaranteed by, a REIT that owns stock in the TRS. Note also that any rents paid by a TRS to a REIT owning more than 10% of the TRS's stock would not be considered qualified rental income under existing REIT tax tests.

Arm's Length Pricing. A 100% excise tax would be imposed on excess payments to ensure arm's length (1) pricing for services provided to REIT tenants (e.g., REIT tenants could not pay for services provided by the TRS through increased rents to the REIT); and (2) allocation of shared expenses between the REIT and the TRS.

Treasury also stated that "certain additional limitations may apply."

Effective Date. The Treasury Department proposed that this provision would be effective after the date of enactment. However, REITs would be allowed to combine and convert third party service subsidiaries into TRSs tax-free "prior to a certain date." Treasury contemplates "a transition period" to allow for conversion of existing subsidiaries before the 10% vote or value test would become effective. Note that the non-REIT shareholders of these subsidiaries would recognize gain upon the conversion into TRSs to the extent they receive property other than REIT stock. Also, there does not appear to be any transition rule for the non-deductibility of interest payments by a third party service subsidiary to its related REIT.

Revenue Raised. The Administration estimated that this provision would raise $137 million over five years.

NAREIT Position

NAREIT believes that these new proposals represent an important and significant step forward, and welcomes the Administration's acknowledgement that tax policy should modernize the REIT rules to conform to the industry's evolution. Most significant is the Administration's agreement that REITs should be able to provide "leading edge" services to their tenants in order to remain competitive. By doing so, REITs would no longer be "at a competitive disadvantage in relation to others in the market," the Administration stated.

While we do not agree with all of the details of this proposal, we look forward to working with Congress as it reviews this proposal to ensure it addresses the realities of the real estate marketplace and the appropriate requirements of the REIT industry. In particular, we believe it is vital that policymakers enact equitable transitional rules for those existing subsidiaries operating fully within the current rules.

Reproposed Closely-held REIT Rules

Background

A year ago, the Administration became aware of a tax strategy under which non-REIT corporations created and then liquidated REITs to defer taxation of interest income for up to three years.

Largely to addresses this "liquidating REIT" stratagem, the Administration proposed in its Fiscal Year 1999 Budget a new ownership test for REITs (beyond the current "Five or Fewer" and "100 Person" rules). Under this proposed test, no entity (without "looking through to its ultimate ownership) could own more than 50% of a REIT's stock (by vote or value). The proposal would have applied to REITs created after the date of first committee action.

The budget legislation passed last October created a separate limitation tailored to the liquidating REIT strategy.

Reproposed Test. In its Fiscal Year 2000 Budget, the Administration once again proposed a new ownership test that would prohibit an entity from owning more than 50% of a REIT's stock (again by vote or value). Apparently, the Treasury Department is aware of other transactions other than the liquidating REIT strategy that it considers to be motivated primarily by tax avoidance.

Significantly, the Treasury Department for the first time recommended that this test not apply to a REIT owning more than 50% of another REIT. This exception would be consistent with the general REIT tests under which REIT stock is considered a "real estate asset." The exception would make sense because ultimately the REIT owning the majority interest in another REIT would have to satisfy the new ownership test. Hopefully, policymakers would apply this exception when a REIT owns its interest in another REIT indirectly through a partnership.

Effective Date. The Administration proposed that this new test apply to entities electing REIT status for taxable years beginning on or after the date of first committee action. In a departure from last year's proposal, the Administration also would apply the new ownership test to an entity electing REIT status for a taxable year before first committee action if it does not have "significant" business assets or activities as of such date. Accordingly, the proposal would apply to "shell REITs" created before the date of first committee action.

The Administration estimates that the proposal would raise $75 million over five years.

NAREIT Position. NAREIT supports the Administration's goal of ensuring that REITs provide an accessible method for ordinary investors to invest in commercial real estate enterprises. While generally supporting the Treasury Department's proposed new ownership test, NAREIT believes that the test should be more narrowly tailored to the perceived corporate tax abuse.

Accordingly, NAREIT looks forward to working with Congress and the Administration as they craft rules to address any perceived abuse, while maintaining investor accessibility to REITs. NAREIT suggests two changes to accomplish these goals. First, the rules should not apply to private REITs that intend to access the public markets after they have created a track record during their "incubation" stage. Second, the rule should apply only to non-REIT C corporations owning more than half of a REIT's stock, since the tax strategies being targeted by the Administration only involve such ownership patterns.

Once Again: Built-in Gains

Background. In the previous three proposed Budgets, the Administration had advocated imposing a double level tax when a C corporation worth more than $5 million elects or merges into an S corporation, mutual fund or REIT. Under the proposal, the excess of the value of the C corporation's assets over their tax bases (the "built-in gain") would have been subject to both a corporate and shareholder level tax, as if the corporation had liquidated. Congress has never seriously considered this proposal, and last year Chairman Bill Archer (R-TX) pronounced it as "dead before arrival."

The Administration's Fiscal Year 2000 Budget once again proposes a double level tax on the above-described built-in gain. The effective date would be for REIT elections that are first effective for a taxable year beginning after January 1,2000 (i.e., for elections starting in 2001), and for C corporation mergers into REITs after December 31, 1999.

Future Action

It is important to remember that the Administration's proposed Budget is but the first step in the legislative process. Congress now must agree to broad parameters for the Fiscal Year 2000 budget, including taxes and spending. Looming large on the horizon is how Congress will address the projected budget surpluses, as well as pending needs such as Social Security, Medicare, defense spending and tax cuts. Only after Congress has approved the blueprints of an overall budget will the tax-writing committees likely start considering any tax legislation.

We will keep you advised of important legislative developments as they occur. If you would like to discuss these proposals in greater detail, call NAREIT's Government Relations Department at 800-3NAREIT.

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NAREIT®, the National Association of Real Estate Investment Trusts®, is the worldwide representative voice for REITs and publicly traded real estate companies with an interest in U.S. real estate and capital markets. NAREIT's members are REITs and other businesses throughout the world that own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service those businesses.